A recession warning signal is flashing; investors carry on

One of Wall Street's traditional warning signs for a recession is flashing yellow, and nobody seems to care.

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The signal lies within the bond market, where Treasurys maturing in a couple years have been paying nearly as much in interest as bonds that take a decade to mature. The gap between the two is usually much wider. Market watchers call this phenomenon a "flattening yield curve," and it's often been a harbinger of slowing economic growth, if not a recession.

Earlier this month, a 10-year Treasury was offering just 0.53 percentage points more in yield than a two-year Treasury. The last time the spread was so thin was in October 2007. Two months later, the Great Recession began.

"The curve normally is the ultimate crystal ball portending recession," said Rich Taylor, client portfolio manager at American Century Investments. "It tells us what the economy will do. And a curve this flat would suggest we have an impending recession."

Yet Taylor and most of Wall Street say that technical factors are making the yield curve a less reliable indicator this time around, and they don't see a recession looming on the horizon, at least not in 2018. Even Federal Reserve chair Janet Yellen echoed the sentiment last week.

How can so many along Wall Street feel so confident saying what have been famous last words for so many market trends: This time is different?

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Taylor said the curve is "flattening for different reasons."

When an economic expansion is several years old and the unemployment rate is low, as it is now, short-term rates are usually moving higher as a result of the Federal Reserve hiking its overnight interest rate.

This year, the Fed has raised short-term rates three times, after doing so just twice in the prior 10 years combined. In response, the yield on the two-year Treasury has climbed to nearly 1.85 percent, up from from 1.25 percent at the end of 2016.

But longer-term interest rates have not followed suit. The Fed has less control over longer-term rates, such as the 10-year Treasury yield, which are affected not only by forecasts for the Fed's rate decisions but also by expectations for inflation, economic growth and other things.

The 10-year Treasury yield is close to where it ended last year, at 2.50 percent compared with 2.47 percent. If the trend continues and short-term rates go higher than long-term rates, it would create what market watchers call an "inverted yield curve." That would be a flashing red light on the warning system because it can indicate the bond market is expecting weak economic growth.

A rule of thumb says a recession would follow in about a year, and an inverted yield curve preceded each of the last seven recessions, according to the Cleveland Fed.

One big reason for longer-term rates being stuck in place is stubbornly low inflation. Raises for workers are a bit healthier than in prior years, and wage growth has historically fed through to higher inflation. But the wage gains are still only modest: about 3.4 percent, according to the Federal Reserve Bank of Atlanta. It was closer to 4 percent before the Great Recession and 5 percent at the turn of the millennium.

Another factor keeping 10-year Treasurys low is all the buying coming from overseas, said Erin Browne, head of asset allocation at UBS Asset Management.

Bonds overseas are paying nearly nothing in interest, and in many cases actually have negative yields. That is pushing buyers from Europe and Asia into 10-year Treasurys, which keeps a lid on rates. That in turn has made the U.S. Treasury yield curve flatter than it would otherwise be.

With central banks in Europe and Japan continuing to buy bonds to help their economies, analysts don't expect their rates to climb much higher, which would keep foreign appetite high for 10-year Treasurys.

"The flattening of the yield curve today is going to have a different impact on growth and corporate health than it has in the past," Browne said. "We don't think that even an inversion of the yield curve, while it certainly would make headlines and people would raise eyebrows, would have the same impact in this cycle as it would historically."

Of course, if Wall Street is underestimating the predictive power of the yield curve this time around, it may be a while before investors are able to tell. Economists don't even say a recession has begun until months after its start.

In the meantime, the yield curve's movements have meant more income for investors whose mutual funds have been buying shorter-term bonds. A two-year Treasury is paying more than triple the interest that it was in the summer of 2016.

"We're more excited than we were a year ago, because we actually have things to look at and there are more opportunities," said Thomas Atteberrry, portfolio manager at the FPA New Income fund, which has been buying two- to five-year bonds due to the rise in yields.